Always on demand?

In a decision with potentially far reaching implications for the shipbuilding industry and for guarantees generally, the English Court of Appeal on 23 July issued a judgment (Shanghai Shipyard Co. Ltd v Reignwood International Investment (Group) Company Limited [2021] EWCA Civ 1147) addressing what makes a guarantee issued by someone other than a financial institution a "demand" guarantee versus a "see to it" guarantee.

The judgment addresses what makes a guarantee issued by someone other than a financial institution a "demand" guarantee versus a "see to it" guarantee. The Court rejected the application of a presumption that a guarantee issued by anyone other than a financial institution should be considered a "see to it" guarantee just because of the status of the guarantor.

What matters are the terms of the guarantee not the characteristics of the guarantor. In addressing how the terms were to be applied, the Court also potentially set up scenarios in a shipbuilding context where shipyards and guarantors race each other to be the first to make a demand to force payment or commence arbitration to prevent or delay such payment.

"Demand" v "See to it" Guarantees

A "demand" guarantee is an absolute undertaking to pay a sum of money without reference to the details of any underlying dispute – so a guarantor is obliged to pay upon receipt of a demand regardless of whether there is a dispute under the underlying contract.

A "see to it" guarantee in contrast is a secondary obligation whereby the guarantor is only liable to the extent that the guaranteed party is – so a guarantor can normally wait for any dispute as to liability arising under the underlying contract to be resolved before becoming obliged to make payment under the guarantee.

In practice, many guarantees issued in a shipbuilding context, particularly by parent companies, contain terms that might on their own be traditionally found in "demand" and "see to it" guarantees. In the Shanghai Shipyard Co. Ltd. v Reignwood International Investment (Group) Company Limited case, first the English Commercial Court and then the Court of Appeal have looked at the guarantee issued by Reignwood to determine how it should be characterised.

The Facts

Shanghai Shipyard Co Ltd (the "Builder") and Reignwood International Investment (Group) Limited (the "Buyer" – later "Guarantor") were parties to a shipbuilding contract dated 21 September 2011 for the construction of a drillship with a total price of USD 200 million. A guarantee was provided by the Guarantor to secure the final instalment of the purchase price of USD 170 million (the "Guarantee") and the contract was novated to bring in a new buyer, Opus Tiger 1 PTE Ltd (the "Novated Buyer"), who was an indirect subsidiary of the Guarantor. The Novated Buyer did not accept delivery of the drillship and the Builder made a demand on the Guarantee. The demand was refused by the Guarantor pending resolution of the dispute as to whether the Novated Buyer was obligated to take delivery which was subsequently submitted to arbitration, but which had not been submitted when the demand was made.

The Guarantee was on terms that are similar to many issued by parent companies pursuant to shipbuilding contracts and included:

  • Clause 1: "In consideration of your entering into the Shipbuilding Contract with [Reignwood] as the buyer ("the Owner") for the construction of one (1) self propelled drill ship with Shipyard's Hull No. S6030 ("the Drillship"), we, [Reignwood] hereby IRREVOCABLY, ABSOLUTELY and UNCONDITIONALLY guarantee in accordance with the terms hereof, as the primary obligor and not merely as the surety, the due and punctual payment by the OWNER of the Final Instalment of the Contract Price amounting to a total sum of United States Dollar US$ 170,000,000 as specified in (2) below…"

  • Clause 3: "We also IRREVOCABLY, ABSOLUTELY and UNCONDITIONALLY guarantee, as primary obligor and not merely as surety, the due and punctual payment by the Owner of interest on the Final Instalment guaranteed hereunder at the rate of five percent (5%) per annum from and including the first day after the default until the date of full payment by us such amount guaranteed hereunder."

  • Clause 4: "In the event that [the Buyer] fails to punctually pay the Final Instalment guaranteed hereunder in accordance with the Contract or [the Buyer] fails to pay any interest thereon, and any such default continues for a period of fifteen days, then, upon receipt by [the Guarantor] of [the Builder's] first written demand, [the Guarantor] shall immediately pay to [the Builder] or [the Builder's] assignee all unpaid Final [I]nstalment, together with the interest as specified in paragraph (3) hereof, without requesting [the Builder] to take any further action, procedure or step against [the Buyer] or with respect to any other security which you may hold.
    In the event that there exists a dispute between [the Buyer] and the Builder as to whether :
    (i) [The Buyer] is liable to pay to the Builder the Final Instalment; and
    (ii) The Builder is entitled to claim the First Instalment from [the Buyer],
    and such dispute is submitted either by [the Buyer] or by [the Builder] for arbitration in accordance with Clause 17 of the Contract, [the Guarantor] shall be entitled to withhold and defer payment until the arbitration award is published. [The Guarantor] shall not be obligated to make any payment to [the Builder] unless the arbitration award order [the Buyer] to pay the Final Instalment. If [the Buyer] fails to honour the award, then [the Guarantor] shall pay you to the extent the arbitration award orders."

  • Clause 7: "Our obligations under this guarantee shall not be affected or prejudiced by:

(a) any dispute between you as the Builder and the Owner under the Contract; …"

First Instance Decision

The Commercial Court was asked to determine two issues:

  1. Whether the Guarantee issued in this instance was a "see to it" or "demand" guarantee;

  2. Whether the Guarantor was entitled to refuse payment under Clause 4 pending the outcome of an arbitration between the parties in respect of a dispute as to the Buyer's liability to pay the Final Instalment:

    1. Only if the arbitration had been commenced between those parties as at the date the demand was made; or
    2. Regardless of when such arbitration was commenced.

In arriving at its decision, the Commercial Court honed in on the fact that the Guarantee was not issued by a bank and, in line with previous authority, concluded that where the instrument was not provided by a bank or other financial institution, there needed to be cogent indications that the instrument was intended to operate as a demand guarantee. Based on the language of the Guarantee and consideration of the factual background, the Commercial Court held that the Guarantee was a "see to it" guarantee.

In respect of the second issue, the Builder argued that even if the Guarantee was a "see to it" guarantee, the proviso in Clause 4 of the Guarantee only operated as a defence to a claim under the Guarantee if the arbitration was commenced before the demand was made (which it had not been in this instance), so that in the absence of an arbitration the Guarantor was obliged to make payment.

The Commercial Court was not persuaded that the benefits of Clause 4 would only arise when the dispute had been submitted to arbitration before the demand under the Guarantee was made and so held that the true construction of the clause entitled the Guarantor to refuse to make payment pending the arbitration outcome notwithstanding when the arbitration was commenced.

The Builder sought permission to appeal from the Commercial Court, which was granted.

Court of Appeal decision

On Friday 23 July 2021, the Court of Appeal unanimously overturned the Commercial Court's decision on both issues.

The First Issue

In respect of the first issue, the Court of Appeal emphasised that:

"What matters for the purposes of counterparty risk is not the nature of the business carried on by the guarantor as such, whether banking, other financial business or commercial trading activity. It is simply the commercial and financial strength and probity of the guarantor. A well-resourced and reputable trading company in an accessible jurisdiction may provide better protection for a beneficiary against counterparty risk than a bank with political affiliations operating in an underdeveloped jurisdiction giving rise to uncertainties of enforcement…Secondly…[the Guarantor] clearly exercised a financing function beyond that which might arise between parent and subsidiary in an established group of companies in relation to the group's business. Thirdly, in the shipbuilding context it has long been established that payment and refund guarantees may be demand guarantees."

The Court of Appeal went on to reference Hyundai Shipbuilding and Heavy Industries Co Ltd v Pournaras [1978] 2 Lloyd's Rep 502, where the payment guarantee was given by an individual and made the point that "If a non-bank gives a guarantee adopting a form of wording which, if given by a bank, would be a demand guarantee", it could not be seen how this would mean something different from an identical instrument issued by a bank – "Such a conclusion would be a recipe for commercial uncertainty and would, in my view, subvert the reasonable expectations of the parties as objectively expressed in the words of their agreement." The Court of Appeal was keen to emphasise that wording took precedence over any assumptions as to the nature of the guarantee based on the Guarantor or otherwise.

The Court of Appeal then turned its attention to the language of the Guarantee and identified the following as being indicators of the Guarantee being a "demand" guarantee as opposed to a "see to it" guarantee :

  1. The capitalised words "ABSOLUTELY and UNCONDITIONALLY" in clauses 1 and 3 of the Guarantee, which conveyed no conditionality on the liability of the Buyer.

  2. The words in clause 1 "[as primary obligor] and not merely as the surety" which are a clear indication that the document was not a surety (i.e. "see to it") guarantee.

  3. The words "upon receipt by us of your first written demand" in clause 4 which "is the hallmark of a demand guarantee".

  4. The wording "we shall immediately pay to you" in clause 4 would not be appropriate in a surety guarantee given the time needed to investigate the underlying liability.

  5. Clause 7(a) which provided that obligations on the Guarantor were to be unaffected by any dispute under the Building Contract. The proviso in Clause 4 was held merely to be a carve out of what is otherwise a demand guarantee – when triggered, "it involves an obligation to pay against a document, namely the arbitration award. It does not involve an obligation to pay in respect of an underlying liability."

The Second Issue

The Builder submitted that in order for the proviso in Clause 4 to be triggered to prevent a payment obligation arising, there must be a dispute and the commencement of arbitration prior to a valid demand being made. The Buyer argued that there only needed to be a dispute in existence. The Court of Appeal disagreed with the Buyer's argument on the basis that if the Buyer were right, "the on demand obligation would be suspended indefinitely by the existence of a dispute and that would occur in every case of non-payment of the delivery instalment."

Comment

This judgment provides guidance as to the factors that will determine whether a guarantee is a "demand" or "see to it" guarantee. Any presumption arising solely from whether the guarantor is a financial institution, parent company or other type of entity has seemingly fallen away. English law will look to the language used without the nature of the entity issuing the guarantee tainting the interpretation. Wording such as 'unconditionally' and 'immediately' and differentiation from traditional "see to it" obligations is likely to mean, regardless of the nature of the entity issuing the guarantee, that it is a demand guarantee.

Where a guarantee has a proviso such as that in Clause 4 which excuses payment where a dispute has arisen and arbitration has been commenced, strict compliance with both aspects will need to be satisfied before any demand on the guarantee is made for the associated payment obligation to be suspended. As such, where similarly worded guarantees are in place, and it becomes apparent that a beneficiary may soon have a right to make a claim on the guarantee, this judgment is likely to lead to arbitrations being commenced urgently before any demand is made so as to give guarantors a basis to suspend payment.

We shall have to wait and see whether this judgment is appealed to the Supreme Court, but in any event this judgment serves as a reminder of the need to be careful in the drafting of guarantees and strict adherence to their terms.

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    Always on demand?

    In a decision with potentially far reaching implications for the shipbuilding industry and for guarantees generally, the English Court of Appeal on 23 July issued a judgment (Shanghai Shipyard Co. Ltd v Reignwood International Investment (Group) Company Limited [2021] EWCA Civ 1147) addressing what makes a guarantee issued by someone other than a financial institution a "demand" guarantee versus a "see to it" guarantee.